Introduction
Man has always tried to optimize trading activities to maximize profits, reducing risks and minimizing losses. From ancient barter trade system till the modern digital currency trading, the evolution of trading has been going on. The advent of cryptocurrencies has helped people merge finance with technology to go a step further in the journey of evolution. In such a complicated financial world, it becomes all the more important to manage trades and, as far as possible, predict future prices in an unpredictable market. Forward and futures contracts are examples of such endeavors.
What are Forward and Futures Contracts?
Forward contract is a formal, private and customizable agreement between two parties to settle the price of a trade that will happen in future. On the other hand, in a futures contract, two parties come to a fixed place and go through procedures to sign a legally binding agreement to trade a commodity on a settled price in future. Speaking simply, the two are the same in that they offer a way to lock a price today for a trade that will happen in the future. They are different in terms of one being carried out privately and the other on exchanges.
Both kinds of contracts target the same thing, but the difference lies in settling the points such as asset amount, delivery date, and whether payment is cash or physical delivery. In futures contracts, exchanges standardize all these details, leaving no room for personal negotiation. This makes futures contracts more secure but less flexible than forwards. On the contrary, forward contracts allow the parties to decide every aspect of the deal according to their needs, which increases customization but also the risk of default.
You might never have heard about forward contracts in the crypto market. This is precisely because forward contracts are private, and they are not carried out on exchanges. That’s why they are not announced in the public. Parties tend to keep such contracts confidential. However, Wintermute is a renowned company that offers forward contracts in crypto assets. Moreover, International Swaps and Derivatives Association (ISDA) also carries out crypto forward contracts.
As far futures contracts in crypto markets are concerned, they are routine affairs on all notable exchanges. So, there is no question about whether crypto market has the forward and futures contracts options.
Origin of Contracts
Europe is credited to have started first forward contracts market in human history. On the other hand, Dōjima Rice Exchange (Japan) is widely regarded as the first official exchange to offer futures trading. During the 18th century, rice was used as a currency. This made the prices of rice very volatile. So, traders started using futures contracts a hedge against the volatility.
The Significance and Rationale of Forward and Futures Contracts in Crypto Market
There are various reasons behind ignoring the spot market and resorting to forward or futures contracts in the crypto market.
Hedging is the foremost of all the reasons. Investors might feel that certain upcoming events may bring volatility and increased uncertainty in the market. To save themselves from the wild swings in price action, they prefer locking the price and entering contracts. For example, if analysts predict a black swan event like war, investors open futures contract to open short positions. Forward contracts are also opened, but as mentioned earlier, they are not publicly disclosed. Also, forward contracts are between companies with significantly large liquidity.
In spot market, there is no option available to use leverage. Investors are attracted to futures contracts due to leverage offers. They can speculate on the price of an asset in the future and borrow money from the exchange to leverage their trading. You can avail yourself of leverage as high as 200 times your wallet balance. This may vary from token to token and from exchange to exchange.
Forward and futures contracts enable crypto analysts to have an idea of the real value of a token. Many buyers and sellers come together in the market to speculate on the future prices. The traders who are still thinking about opening a trade can guess what might happen by looking at the ratio of long and short positions and the amount of leverage used by them. If long positions outnumber the short ones, especially high-margin positions, chances are that the price may pump. Similarly, a heavy leaning of top traders towards short side predicts a correction or a dump.
Exit Strategy for Futures Contracts
When a futures contract starts and moves to the expiry date, the traders have 3 options. They can offset, role over or settle the contracts. Offsetting means opening another contract of equal value in the opposite direction. For example, if a trader has opened a short futures contract with 50 $BTC, they may open an equally heavy long position to neutralize their loss. This is especially a valid option when the contract nears expiry.
Rolling over involves opening an offsetting position just near the expiry date. In this way, the contract will expire much later that the initially decided date.
If neither of the two options is taken, the contract stands expired on the due date and the contract is settled either physically or in cash. In traditional markets, the settlement may take place physically, which means the exchange of commodities. However, in the crypto market, digital currencies is the only option for settlement.
Major Risks
Although cryptocurrency trading is always full of risks, a few major drawbacks make futures contacts even riskier.
Leverage is a trap set by the exchanges. You may feel that you can increase your capital by borrowing from the exchange, but it must be done in moderation. High leverage may liquidate you or hit your stop-loss order far too quickly.
Funding rates may often deprive you of the expected gains. This is true mainly when you keep a position open for a very long time in perpetual contracts.
Lack of liquidity on the exchange, for an asset, or in the market in general may force you to accept an exit price worse than your calculations. This is referred to as slippage.
Conclusion
In a nutshell, a common trader has only the option of futures contract on centralized exchanges. There are quarterly futures that expire at a due date. In addition, perpetual futures can be kept open as long as you want. Always do your diligent research before diving into a trade whether it is a spot trade or futures.
Frequently Asked Questions
What is the key difference between forward and futures contracts?
Forward contracts are private, customizable agreements between two parties, while futures contracts are standardized and traded on exchanges, offering more security.
Why do crypto investors use futures contracts?
Crypto investors use futures to hedge against volatility, speculate on future prices with leverage, and gain exposure without holding the underlying asset.
What are the main risks of trading crypto futures?
Major risks include liquidation from high leverage, unexpected funding rates reducing profits, and slippage due to low liquidity on exchanges.Major risks include liquidation from high leverage, unexpected funding rates reducing profits, and slippage due to low liquidity on exchanges.
